The treble I(s) would, in economic terms be Inflation , Interest Rates and Investments. How I wish ice-cream was one of the I(s) – I love ice-cream. Ice-cream aside , I’d like to shed some light on how the aforementioned three are interrelated.
Inflation by virtue of definition , occurs when demand for goods and services exceed their supply and in other words a situation where too much money is chasing too few goods /services.
This phenomena (monetary) persists when accompanied by a sustained increase in money supply. This situation can be triggered by the private sector and or the government spending more than their revenue streams or by shortfalls in output. Case and example Zimbabwe -a country’s whose inflation was fueled by excessive money supply brought about by unwarranted printing of their local currencies as well as a slow death on their Agricultural sector due to change in ownership of the lands from white-settlers to the locals.
Inflation causes major distortions in the economy hurting mostly those with fixed income. This is because with increased pricing, consumers cannot buy as much as they could previously. Furthermore, it has a detrimental effect on savings reason being money is worth more presently than in the future.
This situation curtails economic growth because the economy requires a certain level of savings to finance investments. Inflation therefore has an inverse relationship with investments.
This macroeconomic condition also makes it harder for businesses to plan for the future. Partly because it poses a difficult scenario for firms when it comes to predicting demand for their products at higher prices and how they’ll cover their costs.
Insofar as commercial banking is concerned, it erodes the value of depositors’ savings and bank loans and as such the uncertainty posed by this phenomena therefore increases the risk associated with investment and production activity of firms and markets.
In an inflationary environment, intermediaries will be less eager to provide long-term financing for capital formation and growth.
I’ll use an example of a simple investment in T-Bills and how inflation has an effect on the real value of the money at the maturity period.
Supposing say Bill buys T-Bills worth $ 3000 that yield a 10% return. Assuming the inflation was positive at 4% during that year. The computation will be as follows
$ 3000* (10%-4%)= 180 when inflation is factored in.
In the absence of inflation:
$ 3000* 10% = 300. (300-180= 120). Inflation takes away $ 120 which would have formed part of Bill’s returns.
Changes in interest rates affect the public’s demand for goods and services and , thus , aggregate investment spending.
Decreased interest rates lowers the cost of borrowing which encourages businesses to increase investment spending. It also gives banks an incentive to lend to businesses and households allowing them to spend more.
On the flip-side , all factors held constant an increase in interest rates in a country increases the value of that currency relative to those that offer lower rates. This situation tends to attract foreign investments due to the higher returns. However an escalating interest rates spurs inflation. This situation is bitter-sweet because it makes exports more expensive than imports which is detrimental but at the same time attract foreign investment. Talk of a tough state of indifference.
Striking the balance on the perfect interest rate to set is always a tough call.
I hope the above write-up sheds some light.
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